The Changing Role of the Federal Reserve
Frederick H. Schultz
W
hen I went to Washington in
1979, most people thought the
Federal Reserve was either a
bonded bourbon or a branch of
the National Guard. In those days, stabilization
theory, which is an economist’s way of saying
steady growth, was based on changeable fiscal
policy and steady monetary policy. The Fed was
a low-profile institution. Milton Friedman was
the most visible of the monetarists, and he went
so far as to say that we might even be able to do
away with the Federal Reserve. He wanted to put
monetary policy on autopilot, and he regarded
fine-tuning as the worst possible option. Now we
have a system in which there is almost universal
agreement that we ought to have a budget that is
in surplus and a Federal Reserve that should be
flexible in monetary policy in order to respond
to changes in the economy. To Milton Friedman’s
consternation, Alan Greenspan is the greatest
fine-tuner in history. We have come a full 180
degrees in the past 20 years.
Why did that happen and what kind of an
organization is the Federal Reserve? A little history. In 1913 the Federal Reserve was created,
primarily to respond to financial panics. In rural
areas, the agricultural banks would be fully committed to commodity loans. Sometimes there
would be a sharp drop in prices and people would
want to take their deposits out of the banks. The
banks would call their loans, farmers would fail,
there would be a run on the banks, and both farmers and bankers would be bankrupt. The Federal
Reserve was created as a lender of last resort so
that the banks could borrow from the Fed until
prices stabilized. In the urban centers, excessive
speculation in financial markets sometimes caused
short-term distress. Again, the Federal Reserve
could provide the banks with liquidity until prices
stabilized. The system worked reasonably well
for several years, including 1921, when we had
a sharp drop in commodities.
But when the Great Depression hit in 1929, a
combination of errors in judgment and structural
flaws prevented the Fed from adequately responding. Structural problems were threefold. First, the
Treasury Secretary sat on the Federal Reserve
Board, so decisions were politicized. Second, the
nation was on the gold standard, which required
the Federal Reserve to be shrinking the money
supply during a time when it should have been
increasing it to fight deflation. Third, the Federal
Reserve did not have authorization to buy and sell
in the open market, a capability used to steady the
money supply. I remember that one of the first
shocks that I had after getting on the Board was
related to open market operations. Every Monday
the staff at the New York Fed and the staff in
Washington did (and still do) their calculations to
come up with an agreement on how much money
needed to be injected into or removed from the
system. I had been on the job for a week when
they made the request to pump $3 billion into
the market. That was the first $3 billion decision
I ever had to make.
The National Banking Act of 1935 fixed the
structural problems but still required the Federal
Reserve to buy any bonds that were issued by the
federal government, with the result of monetizing
the debt. This inflationary threat was changed by
the Treasury Accord of 1951. Since that time, the
Fed has had a high degree of independence.
What kind of organization is the Federal
Reserve? There are about 25,000 employees.
Frederick H. Schultz was Vice Chairman of the Board of Governors of the Federal Reserve System from 1979 to 1982.
Federal Reserve Bank of St. Louis Review, March/April 2005, 87(2, Part 2), pp. 343-48.
© 2005, The Federal Reserve Bank of St. Louis.
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Policymaking is the exclusive domain of the seven
members of the Board of Governors in Washington.
They are all appointed by the President and confirmed by the Senate. The Chairman and Vice
Chairman are confirmed separately, first as
Governor and then as Chairman or Vice Chairman.
There are about 1,500 employees in Washington.
One of my responsibilities was as the administrative governor in charge of the Washington staff.
There are 12 Federal Reserve Banks and more
than 40 branches. Most activity at these institutions involves clearing checks and acting as the
fiscal agent for the government, primarily selling
bonds and accepting various kinds of government
deposits. Although the Federal Reserve Banks can
request changes in the discount rate, they don’t
have any policymaking duties other than those
delegated to them by the Board of Governors in
the area of bank supervision and regulation.
However, they are the eyes and ears of the
Fed. There are 300 economists at the Board in
Washington and an equal number in the Federal
Reserve Banks. The governor of the Bank of
England once told me that compared with the
Federal Reserve, the Bank of England is a
Toonerville Trolley. You may read newspaper
reports about the “Beige Book,” which is made
up of reports from the economic staff of each of
the Federal Reserve Banks. It is used as an important source of information in setting monetary
policy. When I went to the Board, we were shorthanded and Chairman Paul Volcker asked me to
be not only the administrative governor but also
chairman of bank activities, which meant that I
had oversight for all of the Federal Reserve Banks.
This required me to visit each of the Banks on a
regular basis to meet with their president and
board of directors, which helped me to understand what was happening in each section of the
country.
Monetary policy is decided at meetings of
the Federal Open Market Committee (FOMC),
composed of the seven governors and five of the
twelve Federal Reserve Bank presidents, who
rotate their service on the FOMC. The FOMC meets
about every six weeks. During the time I was there,
Volcker and I often had dinner the night before
each meeting. As Vice Chairman, I had decided
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that I would never vote in opposition to Paul on
matters of monetary policy, although he and I
were on opposite sides in a number of regulatory
and supervisory matters. During dinner I would
express my views on the economy and monetary
policy. We would debate those views, and Paul
would outline the direction he wanted to take.
The next morning the meeting would begin with
staff reports on the domestic economy, the international economy, and various monetary options.
Then we would go around the board table and
each governor and Federal Reserve Bank president would give his views. We would then have
a recess and the president of the Federal Reserve
Bank of New York, the staff director for Monetary
Policy, and I would join Paul in his office to discuss what we had heard. When we reconvened,
Paul would do a masterful job of pulling everything together and proposing a course of action.
Debate would ensue and a vote would be taken.
If there were not at least ten affirmatives, Paul
would propose an alternative. This would continue until there was substantial agreement.
What’s it like to be a governor of the Federal
Reserve? In my case, I was appointed because no
one else wanted the job. For two years I had been
on the board of the National Institute of Education.
When Congress created the new Department of
Education, I was on the list to be considered for
secretary. In those days, Charles Kirbo, the senior
partner of King and Spalding in Atlanta, was
Jimmy Carter’s closest advisor. He vetted all the
major appointments. We had a meeting, and after
about 45 minutes he asked me if I would come to
Washington for anything else. When I replied in
the negative, he asked about the Federal Reserve,
which I found interesting. I found out later that
they had been trying to find a banker from the
South to put on the Board. They talked to a couple
of the CEOs of major banks who turned them
down because of the requirement to sell all bank
stocks.
My conversation with Kirbo was on a Monday.
On Wednesday I got a call from Bill Miller, who
was Chairman of the Federal Reserve Board, asking
me to come to Washington for lunch on Friday. I
flew up and we talked for about two hours. At the
end of our discussion, he asked if I would accept
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an appointment if offered. I told him that I could
give him an answer on Monday after discussing
it with my wife over the weekend. When I called
Monday to tell him that I would be willing to
accept, he indicated that I needed to be interviewed by the Vice President and the Secretary
of the Treasury. He set up an appointment for the
next day, and I flew back up for meetings with Vice
President Mondale and Secretary Blumenthal.
Wednesday morning Chairman Miller called to
say that, after their approval, my name had been
submitted to the President. At this point I thought
the process would slow down, but on Friday I was
informed that the President had sent my name to
the Senate. On Monday I called a press conference
for that afternoon, only to be informed that morning that the President had also decided to nominate me as Vice Chairman. Obviously, I was a little
breathless from the speed of events.
When the confirmation process began, I understood that it would take some weeks, so I decided
to accelerate my learning curve. When I had been
a Kennedy Fellow at Harvard, I had audited a
graduate course on macro-economics. I called the
professor and asked him if he could put together
a group of outstanding economists for a meeting.
When I arrived in Cambridge, he had seven economists for lunch. Four of them were Nobel Laureates—Bob Solow, Ken Arrow, Paul Samuelson,
and Franco Modigliani. We had lunch and spent
the afternoon talking. I was trying to get their
advice on what steps we should be taking in handling monetary policy. It was a wonderful afternoon and I learned a lot, but I also heard many
comments that on the one hand we should do
this and on the other hand we should do that. I
remembered that Harry Truman once said, “For
God’s sake, give me a one-armed economist.” After
the meeting, Franco said that he would drive me
back to the hotel. As we raced down city streets
at 70 m.p.h. in his Italian sports car, Franco was
gesticulating not just with one hand but with both,
so I also learned that afternoon never to ride in a
sports car with an Italian economist.
I then decided to try to meet with the major
bankers in New York, since the Federal Reserve
has regulatory responsibility for bank holding
companies. After meeting with Walter Wriston at
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CitiCorp and John McGillicuddy at Manufacturers
Hanover, I went in to see David Rockefeller at
Chase. He came bounding out of his office, grabbed
me by the hand, and said, “Governor, it’s nice to
meet my new boss.” When I got to know him better
later on, and when I learned more about my new
job, I understood he wasn’t just blowing smoke.
My confirmation was difficult. Senator
William Proxmire, chairman of the Senate banking
committee, felt that I was not qualified to be Vice
Chairman and preferred that one of the older,
more experienced members of the Board be chosen
for that office. I met with each member of the
Senate banking committee, with the exception of
the chairman, who chose not to see me. Several
of the Democratic senators were opposed to me
because of my business background. The issue
remained in doubt until the day of the Committee
vote. I finally prevailed 12 to 10, with all Republican senators voting for me. Two and a half years
later, when I was planning to leave the Board,
Senator Proxmire took the floor of the Senate to
comment, “Fred Schultz has done a fine job in a
very difficult time.”
I was sworn in on a Wednesday. On Friday,
Bill Miller called to say that he was resigning as
Chairman of the Board to accept the position of
Secretary of the Treasury. My reply was “Well,
thanks a hell of a lot.” Over the weekend the
rumor went around that I was to be the next Fed
Chairman. Monday morning was the most humbling experience of my life. The currency markets
opened in Europe and the dollar dropped like a
rock. That afternoon the President announced that
Paul Volcker was going to be the next Chairman,
and the dollar shot right back up again.
During this time, the economy was really
beginning to deteriorate. The summer of 1979 was
certainly the most difficult economic crisis this
country has experienced since the Great Depression. There was a growing flight from the dollar.
Everybody was getting out of intangibles and into
tangibles. They were selling stocks and buying real
estate or gold or jewels or stamps or anything to
protect them against inflation. One of the members
of the Board was a great international economist
named Henry Wallich. He had been a young boy
in Germany in 1923. He used to tell a story that
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he would go down to the community swimming
pool where the nominal charge for an eight-yearold boy was 5 billion marks. He had to get a large
basket and fill it with currency in order to go
swimming. In those days people in Germany were
paid twice a day. They were paid at noon and took
their check and spent it immediately because
between noon and the time they got paid again
at 5:00 the value of the currency would have
already dropped dramatically. Wallich used to say
that he never, never thought these things could
occur in the United States. But in the summer of
1979, he used only one never.
Chairman Volcker recognized that he needed
to do something dramatic, so he proposed that we
adopt a strict monetary rule based on movements
of the money supply. We understood that interest
rates would have to go up very sharply, but none
of us believed that they would go as high as they
did. We rather thought that 15 percent would do
the job, but the prime actually went as high as
20.5 percent. It was a very difficult period, with
enormous pressure on the Board. My day began
at the office at 7:30 in the morning and lasted until
7 or 7:30 at night. I took home a briefcase with a
sandwich and reading material, ran for about three
miles, and got into bed to work until midnight.
About 350 pages of reading material came across
our desks everyday. Even with assistants and an
excellent staff, it was still necessary to work every
night. Volcker would come in at about 9:00 in the
morning but seldom left before 9:00 at night. He
lived in a little one-bedroom apartment about three
blocks away, cooked his own dinner on a hot plate
and worked until 1:00 or 2:00 at night. That was
the way we lived for one solid year. I didn’t read
a book or watch a movie. I didn’t turn on the TV
except to watch the Super Bowl.
Unfortunately, things continued to get worse.
In January the Carter administration submitted
a budget that widened the deficit. The markets
reacted dramatically, thinking that inflation was
going to get out of control. There was a law on the
books, which had been put in under President
Nixon’s administration, allowing credit controls.
It was invoked by the President but administered
by the Federal Reserve. When President Carter
invoked credit controls, Volcker put me in charge.
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That was the worst job I have ever had. I had a
staff of about 80 economists, but you cannot
imagine how enormously complex our economy
is. Every time we put out a regulation to try to
take care of one problem, we would find that we
had created two or three others in the process.
This economy is a remarkable invention. It works
amazingly well, but when you interfere with it,
myriad unanticipated problems are created. In
the final analysis, people were reacting by cutting
up their credit cards and restricting most of their
borrowing. The economy dropped precipitously,
and we removed the credit controls as quickly as
we thought we could. We misjudged. The economy quickly overheated again, and we were put
into the difficult position of having to raise interest rates in August, just prior to the election.
The Federal Reserve is a thoroughly nonpolitical institution. I never heard politics discussed
at the Board table while I was there, but we did try
to make any moves as far away from an election
as possible. We were anxious not to be seen as
trying to influence the outcome one way or the
other. I don’t think any Federal Reserve Board has
ever increased rates as close to an election as we
did. I got a call from a friend of mine at the White
House who said, “What in the hell do you think
you’re doing?” I explained that we really didn’t
have a choice. If we didn’t raise rates, the inflation
problem would get worse and it would mean that
we would have to raise them even more at a later
time. He replied, “Well, you’ve got to do what
you’ve got to do,” and that was the end of it.
Jimmy Carter may have had his problems as
President, but in certain settings he was as sharp
as anybody I have ever seen. One Saturday night
when we were working on credit controls, I was
called to the cabinet room of the White House to
meet with the President, Vice President, Secretary
of the Treasury, and head of the Office of Management and Budget. President Carter’s questions
came like a machine gun. He was superbly knowledgeable and very much in charge.
During this period, we had a lot of international pressure as well. While I was there I can’t
remember a head of state who came to Washington
without seeing Paul Volcker. I saw a lot of finance
ministers and foreign ministers. The Fed was very
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much the focus of what was going on in the world.
We were trying to explain to them what we were
trying to do. I remember one meeting in Basel,
Switzerland, of the Bank for International
Settlements, which is a kind of central bankers’
central bank. There are some 80 countries that are
members, with 11 on the executive committee.
The meeting begins on a Monday afternoon with
a so-called “tour d’horizon,” tour of the horizon,
where each country on the executive committee
reports on how they see the economy of the world.
I was representing the United States, and the
Governor of the Bank of England turned to me
and said, “Well, I think we should first hear from
the Federal Reserve because they’re the elephant
in the lifeboat.”
The Vice Chancellor of Austria once came to
my office to ask if I would be willing to do an
interview with him, which he would use in his
reelection campaign. I agreed on the condition
that we just talk economics. Evidently he used
the interview on television to explain Austria’s
economic problems. It must have worked, because
he got reelected.
In January 1981, the Reagan administration
took office. They were committed to the supplyside approach, which required a big cut in taxes.
At the Federal Reserve we thought a tax cut would
be helpful. Unfortunately, Congress commandeered the bill and the logrolling began. The
special interests had a field day: wood stoves in
Vermont, racehorses in Kentucky, peanuts in
Alabama. It got so bad that in June the Reagan
administration seriously questioned whether they
should try to pass the bill. The Federal Reserve
opposed it. Volcker had a number of meetings
with members of the Senate and I with members
of the House. About two weeks after the bill was
passed, I saw Bob Dole in the elevator of the apartment house where we both lived. Even though
he had helped pass the bill, he said, “I think you
were right.” He then put in a bill to rescind many
of its most egregious provisions.
During the early years of the Reagan administration, there was a battle between the Treasury
and the Fed. Don Regan was Secretary of the
Treasury, and he had assembled an economic team
of committed supply-siders who were concerned
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primarily with supporting their theory. When the
economy didn’t work in sync with their theories,
they were quick to blame the Federal Reserve.
After enduring this criticism from every direction,
I finally bought a large child’s top with a plunger
to make it spin. I had it painted four different
colors labeled “supply side,” “Keynesianism,”
“monetarism,” and “gold standard.” I sent it to
Don Regan with a note that he could have any kind
of monetary policy he wanted if he just pushed
the plunger up and down. Don was not a very good
economist, but he had a quick wit. Three days later
I received a box with a yo-yo in it and a note saying that everything would be all right if the Fed
would stop yo-yoing the money supply. When Jim
Baker came in as Treasury Secretary, he adopted
a much more pragmatic approach and relationships with the Fed improved considerably.
Throughout the 1980s, problems were created
by budget deficits and tight monetary policy. In
1990, President Bush recognized that this was not
the optimum way to run economic policy. He
proposed a tax increase. From an economic point
of view, I think this was very right and very courageous, but it was politically devastating. When
people are assessing credit for the extraordinary
good times of the late 1990s, George Bush deserves
some of the credit. When the Clinton administration took office, they raised taxes further to create
a balanced budget. That enabled the Fed to lower
interest rates. When combined with advances in
technology, this encouraged businesses to dramatically increase their capital expenditures. The
result was a surge of productivity that has enabled
us to have a strong economy without inflation.
Now we are in a period where we have totally
reversed the economic policies of the 70s. I don’t
know of any responsible Republican or Democrat
who argues that we ought to have an unbalanced
budget at this point in time. They may argue about
the level of taxes or the level of spending, but no
one espouses anything other than a tight fiscal
policy with any necessary adjustments accomplished by a flexible monetary policy. The Achilles
heel of the system is that it is deeply dependent
upon the Chairman of the Federal Reserve. We
have had the two greatest Federal Reserve Chairmen in history: Paul Volcker and Alan Greenspan.
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Alan told me two years ago that “the people of
the United States will never understand how
much they owe to Paul Volcker.” Paul had the
intellect and the courage to handle the difficult
crisis of the late 1970s and early 1980s. On the
other hand, Alan Greenspan is the best I have
ever seen in sensing where we are in the business
cycle.
When I first got on the Board, I called former
Chairman Arthur Burns and asked him to have
lunch. I wanted to ask him what characteristics
of a governor of the Federal Reserve were, in his
opinion, the most important. He puffed on his
pipe and in his gravelly voice replied, “Common
sense and good judgment.” The President of the
United States will appoint a new Chairman of the
Federal Reserve. He needs to find someone who
is a brilliant and experienced economist, but more
than anything else, he needs to find someone with
common sense and good judgment.
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